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Volume Analysis (Part III of IV)

05/21/01 03:41:02 PM
by Dennis D. Peterson

Volume tells us how many shares are traded and thus gives us a measure of buying and selling enthusiasm.

Security:   QQQ
Position:   N/A

You can also see volume and price in action by taking a larger view and using a moving average. I have annotated volume in Figure 1 with a 10-day moving average. You can see volume is in-gear with price from early 1999 to September 2000. As prices increased from early 1999 through April 2000, volume also slowly increased. Price action and volume were still in-gear up to September 2000. After September the selling wasn't due solely to profit taking or price adjustments; it was panic-type selling. A market that loses more than 70% (from QQQ=120 to QQQ=36) isn't normal.

The market didn't get to its current value of QQQ without some thrashing however. Going back to the article "Using Gann", posted 4/20/01, you will see that the consolidation zone was rather large, starting at QQQ=84 and ending at QQQ=54. The market did struggle with the decline in QQQ.

Figure 1: QQQ daily price and volume. Volume is overlaid with a 10-day moving average.
Graphic provided by: MetaStock.
Graphic provided by: Data vendor: eSignal<.
But how far back do you need to go to find the market's comfort zone? Not much more than a few months, maybe six. Looking at QQQ, with much of the detail lost due to the compaction of the picture, most of the decline was due to panic-type selling. Unfortunately many people lose money when out of gear selling occurs. Does that mean QQQ will return soon? At this level I can only see one in-gear move -- it is short and would let QQQ get back to around 56. There is no point in going back much further than what I have shown with the single vertical line. The economy that drove QQQ to 120 is gone. The market just cares about the next six months relative to where we are today. The market will recover, but as some have wisely pointed out, only if you live long enough.

I need to make a clarification about being in-gear and out-of-gear. The time frame normally used is one or two weeks or less when considering whether a stock or market has made an in-gear or out-of-gear move. When the time frame stretches over a month or more, an in-gear or out-of-gear analysis is less appropriate. To be technically correct I continued to describe the long QQQ downtrend on increasing volume as an out-of-gear move. What makes downtrend from September 2000 through April 2001 an out-of-gear move is that the drop wasn't due to profit taking. There was a degree of panic selling - selling to avoid further loss.

You will run across charts that have very low volume: daily volume in thousands as opposed to millions of shares for the last several months. I wouldn't trade them. Low volume means no interest, and with no one interested, the price won't move in any kind of predictable manner. But keep an eye on the share price - institutions often stay away from stocks that are less than $5/share and some don't buy anything less than $10/share. Without institutional buying and selling, volume is often too low to use.

After you go through this detailed analysis, ask yourself how often has panic selling versus overexuberant buying occured? How long have the uptrends versus the downtrends lasted? If they are about equal, I will conclude neither the bulls nor bears are in charge. When they are not equal, either the bulls or bears have taken charge. When neither is in charge, I don't expect big moves. If one of them has taken charge, I expect some strong moves to occur. Right now (5/10/2001), for QQQ, no one is dominating.

The logical extension to price that is subject to both overexuberant buying and panic-type selling is that price volatility is high. Traders and investors are reacting. It is during the quiet periods that the market is making a decision. This could mean that the market will either go into an uptrend or downtrend. Volume analysis lets you distinguish the quiet periods of decision-making versus the high volatility of overreaction.

Prices go up based on demand or scarcity. Scarcity is created when there are fewer sellers than there are buyers. Prices go down when there is a lack of demand or more sellers than buyers. A price top can occur because there is a lack of sellers and vice versa for a bottom.

When I first introduced the notion of buying enthusiasm I didn't want to complicate the picture with scarcity. What often happens is that those who buy near the top are waiting to see how much profit they can make. Selling therefore slows down. With fewer sellers, that is, fewer trades, price goes up on lowered volume. Maybe it's like the Tulip frenzy in Holland long ago, but the market won't support prices based on scarcity. IPOs often go up based on scarcity, but then come back down. Tops created by scarcity often have dramatic selloffs.

There are other ways that a top and bottom manifest themselves in terms of price and volume. Two that are easy to remember because they are complimentary are the exhaustion top and selling climax. A quick rise in prices accompanied by a sudden rise in volume that occurs over a week's time is typical of a buying frenzy and will likely result in a major or intermediate top. Conversely, a selling climax is a sudden rise in volume with a sudden decrease in prices over a few days time and is most likely a bottom. A trend change is more likely with a selling climax than an exhaustion top. The critical factor is the length of time - in days not weeks.

Dennis D. Peterson

Market index trading on a daily basis.

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Date: 05/22/01Rank: 4Comment: 

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